Income-based business valuation
To capitalize or discount?
Given these two ways of doing the same thing you may wonder:
As the math below demonstrates, there are specific situations when these two types of business valuation methods produce identical results. Strictly speaking, the following is true:
Business Appraisal by Discounting its Cash Flow
This offers some useful insights:
Business Valuation by Capitalized Multiple of Earnings
If business earnings vary significantly over time, your best bet is to rely on discounting when valuing a business. Since you can make accurate earnings projections only so far into the future, the typical procedure is this:
Take a look at the present value discount formula:
Where CF0 is the business cash flow as of the business valuation date, g is the constant annual growth rate in the cash flow, and d is the discount rate.
Now compare the above with the well-known result for the sum of the so-called geometric series:
Note that the present value is just the geometric series less the first term, which is equal to 1. Now make this substitution:
Which gives us the famous constant growth capitalization formula:
Business Valuation Tools